USWB <news>
Headline: USWEB CORP (NASDAQ:USWB) files SEC Form 10-Q
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ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion and analysis of the financial condition and results
of operations of USWeb Corporation (which is also known as and referred to as
"USWeb/CKS") should be read in conjunction with the Company's consolidated
financial statements for the year ended December 31, 1998 filed with
USWeb/CKS' Annual Report on Form 10-K.
The following discussion contains forward-looking statements about matters
that involve risks and uncertainties, such as statements of the Company's
plans, objectives, expectations and intentions, as well as financial trends.
The discussion also includes cautionary statements about these matters. You
should read the cautionary statements made below as being applicable to all
related forward-looking statements wherever they appear in this document.
USWeb/CKS' actual results could differ materially from those discussed below.
Factors that could cause or contribute to such differences include those
discussed in "Risk Factors," as well as those discussed elsewhere herein.
Overview
USWeb/CKS is a leading Internet professional services firm that provides
intranet, extranet and Web site solutions, advertising and branding services,
and related services to businesses. USWeb/CKS has built a network of
consulting offices and what we believe to be one of the most recognized brands
for Internet professional services. USWeb/CKS offers a comprehensive range of
services to deliver Internet solutions designed to improve clients' business
processes. We provide Internet professional services including strategy
consulting, analysis and design, technology development, systems
implementation and integration, audience development and maintenance. We also
provide consulting services in the areas of strategic corporate and product
positioning, corporate identity and product branding, new media, environmental
design, packaging, collateral systems, advertising, direct marketing, consumer
and trade promotions and media placement services.
On December 17, 1998, USWeb Corporation completed its merger with CKS Group,
Inc. ("CKS Group") in a transaction accounted for as a pooling of interests.
Accordingly, our historical financial statements have been combined to present
the historical consolidated financial statements of USWeb Corporation and CKS
Group for all periods presented. Under terms of the merger agreement, each
outstanding share of CKS Group common stock was exchanged for 1.5 shares of
USWeb Corporation Common Stock.
USWeb Corporation was incorporated in December 1995. From the date of its
incorporation to March 31, 1997, our operating activities related primarily to
recruiting personnel, raising capital, and conducting business as a franchisor
of Internet professional services firms. Each such firm that entered into a
franchise agreement with us was designated an "Affiliate." In March 1997, we
entered into our last Affiliate agreement and do not expect to enter into any
additional Affiliate agreements. In the first quarter of 1997, we initiated
the second phase of our corporate development strategy and began to acquire
Internet professional services firms, starting with some of the Affiliates. To
date, USWeb/CKS has derived its revenues from a combination of service
revenues generated by its USWeb/CKS-owned offices and fees paid by Affiliates.
Revenues from USWeb/CKS-owned offices represented approximately 99% of total
USWeb/CKS revenues for the quarters ended March 31, 1999 and 1998.
CKS Group was founded in 1987 as Cleary Communications and initially
concentrated on the development and implementation of marketing plans and
programs. Over the last few years, CKS Group developed its vision as an
integrated marketing communications company utilizing both traditional
marketing disciplines, such as product branding and advertising, and advanced
technology solutions and new media, including Internet development, intranet
development, database architecture and enterprise systems integration.
The Company has only a limited operating history upon which to base an
evaluation of its business and prospects. The Company and its prospects must
be considered in light of the risks, expenses and difficulties frequently
encountered by companies in an early stage of development, particularly
companies in new and rapidly evolving markets such as Internet professional
services. Such risks for the Company include, but are not
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limited to, an evolving business model and the management of both internal and
acquisition- based growth. To address these risks, the Company must, among
other things, continue strategic expansion of its network of consulting
offices, continue to develop the strength and quality of its operations,
maximize the value delivered to clients, enhance the Company's brands, respond
to competitive developments and continue to attract, retain and motivate
qualified employees. The Company may not be successful in meeting these
challenges and addressing such risks, and the failure to do so could have a
material adverse effect on the Company's business, results of operations and
financial condition. The Company has incurred net losses since inception, and
as of March 31, 1999 had an accumulated deficit of $299 million. Although the
Company has experienced revenue growth in recent quarters, such growth rates
may not be sustainable or indicative of future operating results. The Company
expects to continue to incur substantial operating losses through at least
1999, and may not achieve or sustain profitability. See "Risk Factors--We Have
Only a Limited Operating History . . . " and "--We Have a Large Accumulated
Deficit . . . "
Acquisitions
In 1996, we began to acquire selected Internet, marketing communications and
related technology services firms. We transitioned from a franchise-based
business model to one based on USWeb/CKS-owned operations to provide greater
economies of scale, enable the consulting offices to focus on providing
professional services and facilitate their growth by furnishing needed working
capital. USWeb/CKS typically determines the purchase price of each acquisition
candidate based on strategic fit, geographic coverage, historical revenues,
profitability, financial condition and contract backlog, and our qualitative
evaluation of the candidate's management team, operational scalability and
customer base.
USWeb/CKS typically acquires suitable candidates through mergers in exchange
for shares of its Common Stock, cash, or a combination of both. Generally,
with respect to past domestic acquisitions, at least fifty percent of the
shares to be issued are deposited into a one-year escrow (or otherwise
deferred) and the remaining shares are delivered to the acquired company's
shareholders. The acquired company is valued again, typically at each of six
and twelve months after acquisition, and additional shares are issued to the
acquired company or escrowed shares are returned to USWeb/CKS depending on
whether the valuation has increased or decreased. After all such purchase
price adjustments have been made, all shares remaining in escrow are issued to
the acquired company's shareholders. USWeb/CKS expects to continue using this
valuation and payment methodology for most of its future acquisitions;
however, in certain situations USWeb may use other methodologies as
appropriate. We may increasingly use cash to pay for acquisitions and, in
particular, intend to increase our use of cash in international acquisitions.
Of the 44 acquisitions completed by USWeb and CKS Group to date, 41 have
been accounted for as purchase business combinations and three, including the
acquisition of CKS Group, have been accounted for as poolings of interests.
For each purchase business combination to date, a portion of the purchase
price was allocated to the tangible and identifiable intangible assets
acquired and liabilities assumed based on their respective fair values on the
acquisition date. Identifiable intangible assets include:
. amounts allocated to in-process technology and immediately charged to
operations,
. amounts allocated to completed technology and amortized on a straight-
line basis over the estimated useful life of the technology--generally
from six months to one year,
. amounts allocated to workforce in place and amortized on a straight-line
basis over the estimated period of benefit, which ranges from twelve to
forty-two months, and
. amounts allocated to goodwill and amortized on a straight-line basis
over twelve months to twenty years.
For each purchase business transaction, the results of operations of an
acquired entity are consolidated with those of USWeb/CKS as of the date
USWeb/CKS acquires effective control of the entity, which may occur prior to
the formal legal closing of the transaction and the physical exchange of
acquisition consideration.
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To determine the amounts to be allocated to acquired in-process technology
we used two distinct approaches. For all acquisitions except Gray Peak
Technologies, Inc. ("Gray Peak"), we performed an internal detailed valuation.
For the acquisition of Gray Peak, which was individually significant at the
time it was acquired, we engaged a valuation consultant to perform an
independent valuation of the Gray Peak purchase price including an allocation
of such purchase price to assets acquired and liabilities assumed. Should
USWeb/CKS fail to complete acquired in-process technology, we may not be able
to recover costs invested in development of such technology or realize any
anticipated future net cash flows.
Generally, the employees of acquired companies who become employees of
USWeb/CKS are granted options to purchase shares of USWeb/CKS' Common Stock,
which typically become exercisable over a 36-month period. These options have
an exercise price per share equal to at least the fair market value of
USWeb/CKS Common Stock on the date of grant. Additional options generally are
granted at the revaluation dates if the target company's formula-based
valuation increases. In most cases, each optionee is also given the right to
receive a stock bonus at the time an option is granted. The stock bonus vests
at the same rate as the corresponding option and is equal in value to the
aggregate exercise price of this option. The stock bonus is payable at the
earlier of three years from the date of grant or, to the extent vested, upon
termination of employment. The stock bonus amount is amortized ratably over a
36-month period and recorded as compensation expense. This charge is
identified as "Stock Compensation" and allocated to either cost of revenues or
operating expenses depending on whether the optionee is acting in a service
delivery or administrative capacity.
During the year ended December 31, 1998, options for our Common Stock were
exchanged for outstanding vested options for the acquired entity's Common
Stock only with respect to the acquisitions of Gray Peak, Ikonic Interactive,
Inc. ("Ikonic"), and CKS Group. In the acquisitions of Gray Peak and Ikonic,
which were accounted for as purchase business combinations, the value of such
options was determined using the Black-Scholes option pricing model and
included in the determination of purchase price. For transactions in which
option vesting was accelerated as a result of the merger transaction, the
vested options were required to be exercised prior to acquisition and the
resultant target company shares exchanged for our Common Stock. Options
granted to new employees with exercise prices equal to the fair value of the
Company's Common Stock on the date of grant in exchange for future services
are accounted for in accordance with Accounting Principles Board Opinion No.
25, with no compensation expense recognized in our consolidated financial
statements. Options granted to consultants with non-variable terms are valued
on the date of grant using the Black-Scholes option pricing model. The
resulting compensation cost is allocated to cost of revenues or operating
expenses depending on whether the optionee is acting in a services delivery or
administrative capacity.
To capitalize on the growth opportunities for a newly acquired consulting
office, USWeb/CKS generally hires a number of additional Internet
professionals during the three-month period following the office's integration
into the USWeb/CKS network. The capacity utilization rates of these new
employees are initially not as high as those of seasoned employees because of
the time spent on training and professional development. Consequently,
USWeb/CKS expects that the cost of service revenues as a percentage of service
revenues of an integrated office will generally increase during the first
three months following such integration. We believe that this investment in
training and professional development will contribute to our ability to meet
growth targets.
The successful implementation of USWeb/CKS' acquisition strategy depends on
its ability to identify suitable acquisition candidates, acquire such
companies on acceptable terms and integrate their operations successfully with
those of the Company. USWeb/CKS may not be able to do so. Moreover, in
pursuing acquisitions USWeb/CKS may compete with companies with similar
acquisition strategies, certain of which competitors may be larger and have
greater financial and other resources than USWeb/CKS. Competition for these
acquisition targets could also result in increased prices for acquisition
targets and a diminished pool of companies available for acquisition.
Acquisitions also involve a number of other risks, including adverse effects
on USWeb/CKS' reported operating results from increases in goodwill
amortization, acquired in-process technology, stock compensation expense and
increased compensation expenses resulting from newly hired employees, the
diversion of management attention, risks associated with the subsequent
integration of acquired
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businesses, potential disputes with the sellers of one or more acquired
entities and the failure to retain key acquired personnel. Client satisfaction
or performance problems with an acquired firm could also have a material
adverse impact on the reputation of USWeb/CKS as a whole, and any acquired
subsidiary could significantly under-perform relative to USWeb/CKS'
expectations. For all of these reasons, USWeb/CKS' pursuit of an overall
acquisition strategy or any individual completed, pending or future
acquisition could harm USWeb/CKS' business, results of operations and
financial condition. To the extent USWeb/CKS chooses to use cash consideration
in the future to pay for all or part of any acquisitions, USWeb/CKS may be
required to obtain additional financing. Such financing may be unavailable on
favorable terms, if at all.
Strategic Alliance
In May 1998, USWeb Corporation entered into a strategic alliance with NBC
Multimedia, Inc. ("NBC") to expand production capabilities for NBC's
interactive properties and services. As part of the strategic alliance, we
were awarded a multi-year contract where revenues earned under the contract
are expected to approximate $11.0 million. In connection with the strategic
alliance, we issued warrants to NBC allowing them to purchase 1,600,000 and
500,000 shares of our Common Stock at $22.50 and $25.43 per share,
respectively. Warrants to purchase 1,050,000 shares are exercisable at any
time prior to their expiration in November 1999 (the "Fixed Warrants"). If the
agreement is cancelled by NBC Multimedia, Inc. before May 2002, USWeb/CKS can
cancel the warrants to purchase the remaining 1,050,000 shares or, if the
warrants have been previously exercised, can repurchase the associated shares
issued (the "Variable Warrants"). The warrants were initially valued at
$12.6 million. Of the total value ascribed to the NBC warrants, $6.3 million
was attributable to the Fixed Warrants and recorded as part of stock
compensation in operating expenses. The remaining $6.3 million of the initial
value was attributed to the Variable Warrants, which are included as part of
the costs of the NBC contract. The Variable Warrants are subject to
revaluation at each balance sheet date through the date the related
cancellation or repurchase rights lapse. The Variable Warrants were revalued
at March 31, 1999, and the original charge was increased by $11.2 million to
$21.2 million based on current market data. Because the inclusion of the value
of the Variable Warrants as part of the NBC contract results in an overall
loss on the contract, this amount was recognized as a provision for loss on
contract.
As a result of the purchase accounting adjustments, the stock compensation
charges and the charges associated with the NBC warrants described above,
USWeb/CKS has incurred significant non-cash expenses. In addition to the
charge associated with NBC warrants, stock compensation expense included in
cost of revenues totaled $4.4 million, stock compensation expense included in
operating expenses totaled $9.1 million and amortization of intangible assets
totaled $29.5 million, all of which were related to the acquisition of
USWeb/CKS-owned offices. In addition, USWeb/CKS has recognized an aggregate
cost of $0.8 million for acquired in-process technology related to the
acquisitions it completed during the quarter ended March 31, 1999. USWeb/CKS
expects these acquisition-related non-cash expenses to continue on a basis
corresponding with operation of the acquisition program.
Sources of Revenues and Revenue Recognition
USWeb/CKS consolidates the financial statements of acquired entities
beginning on the date USWeb/CKS assumes effective control of those entities.
Revenues primarily consist of fees from consulting services engagements
(including both time-and-materials and fixed-price engagements). We provide
Internet professional services including strategy consulting, analysis and
design, technology development, systems implementation and integration,
audience development and maintenance. We also provide strategic corporate and
product positioning, corporate identity and product branding, new media,
environmental design, packaging, collateral systems, advertising, direct
marketing, consumer and trade promotions and media placement services.
Revenues from time-and-materials engagements are recognized as services are
provided and revenues from fixed-price engagements are recognized using the
percentage-of-completion method. Billable rates vary by the service provided
and geographical region. Although a majority of engagements are currently
performed on a time-and-materials basis, USWeb/CKS intends to increase the
percentage of its engagements that are based on a fixed price. The pricing,
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management and execution of individual engagements are the responsibility of
the consulting office that performs or coordinates the services.
Classification of Costs
Cost of revenues include direct costs, such as personnel salaries and
benefits and the cost of any third-party hardware or software included in an
Internet solution, and related overhead expenses, such as depreciation and
occupancy charges, associated with the generation of the revenues. The
technology, sales, marketing and administrative costs of each USWeb/CKS-owned
office are classified as operating expenses. Corporate expenses are primarily
classified as operating expenses. Marketing and sales expenses include product
and service research, advertising, brand name promotions and lead-generation
activities, as well as the salary and benefits costs of the personnel in these
functions. General and administrative expenses include administration,
accounting, legal and human resources costs.
Results of Operations (Dollars in thousands)
Three months ended March 31,
-----------------------------------
% of % of
1999 Revenue 1998 Revenue
-------- ------- -------- -------
(Unaudited)
Revenues................................ $ 84,112 100 % $ 39,325 100 %
-------- --- -------- ---
Cost of revenues:
Services.............................. 52,926 63 26,750 68
Provision for loss on contract........ 11,215 13 -- --
Stock compensation.................... 4,408 5 1,681 4
-------- --- -------- ---
Total cost of revenues.............. 68,549 81 28,431 72
-------- --- -------- ---
Gross Profit............................ 15,563 19 10,894 28
-------- --- -------- ---
Operating Expenses
Marketing, sales and support.......... 8,855 11 5,261 13
General and administrative............ 14,033 17 9,358 24
Acquired in-process technology........ 823 1 4,323 11
Stock compensation.................... 9,148 11 2,568 7
Amortization of intangible assets..... 29,473 35 4,860 12
Merger and integration costs.......... 5,316 6 -- --
-------- --- -------- ---
Total operating expenses............ 67,648 81 26,370 67
-------- --- -------- ---
Loss from operations.................... (52,085) (62) (15,476) (39)
Interest income, net.................... 901 1 925 2
-------- --- -------- ---
Loss before income taxes................ (51,184) (61) (14,551) (37)
-------- --- -------- ---
Provision for income taxes.............. 491 1 704 2
-------- --- -------- ---
Net loss................................ $(51,675) (62)% $(15,255) (39)%
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Revenues. Total revenues increased $44.8 million or 114% during the three-
month period ended March 31, 1999, compared to the corresponding period ended
March 31, 1998. This increase resulted from an increase in the number and
relative size of client engagements we have undertaken as well as revenue
recognized by companies acquired subsequent to March 31, 1998. During the
three months ended March 31, 1999, revenue related to acquisitions completed
subsequent to the three-month period ended March 31, 1998 was $28.3 million.
USWeb/CKS recognizes revenues related to fixed fee for service projects using
the percentage of completion method based on the ratio of costs incurred to
total estimated project costs. USWeb/CKS updates its estimated costs on each
project monthly. Fees and expenditures in excess of billings represents the
costs incurred and
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anticipated profits earned on projects in progress in excess of amounts
billed, and is recorded as an asset. Billings in excess of fees and
expenditures represents amounts billed in excess of costs incurred and
estimated profits earned, and is recorded as a liability. To the extent costs
incurred and anticipated costs to complete projects in progress exceed
anticipated billings, a loss is accrued for the excess.
We generally generate higher profit margins when a greater percentage of our
services are performed by full-time employees rather than independent
consultants. Accordingly, USWeb/CKS actively monitors and manages its level of
full-time and temporary employees as compared to independent consultants to
ensure that future projects are adequately staffed. In certain instances,
USWeb/CKS has made a strategic decision to incur the incremental costs of
independent consultants to staff growth in projects rather than increase the
number of full-time employees until such time as USWeb/CKS has determined that
the increased revenue levels are sustainable. We anticipate that revenues in
future periods will vary depending on our internal growth and management of
growth, and as a result of any acquisitions and the integration of acquired
firms.
Cost of Revenues. Cost of revenues increased $40.1 million or 141% during
the three-month period ended March 31, 1999 compared to the corresponding
period in 1998. This increase primarily resulted from increases in the number
and relative size of client engagements we have undertaken as well as cost of
revenues recognized by companies acquired subsequent to March 31, 1998. During
the three months ended March 31, 1999, cost of revenues related to
acquisitions completed subsequent to the three-months ended March 31, 1998 was
$19.5 million. Included in cost of revenues for the period ended March 31,
1999 is a provision for contract loss of $11.2 million related to the NBC
warrants discussed above. We anticipate that cost of revenues will increase in
absolute dollars as a result of internal growth and as a result of any
acquisitions we may complete.
___ more later_____ |
